Setting Up your LLC with an S-Corp Designation
One of the biggest and hardest decision that new entrepreneurs make when starting out is if they want to incorporate as a Limited Liability Corporation (LLC) or as a Small Business Corporation (S-Corp). Both designations offer unique advantages and it’s important to know the benefits of both. If you haven’t had a chance, make sure to check out our article about the three main types of corporate entities.
What you may not know is that you can have your LLC treated like an S-Corp to gain the tax advantage of S-Corps while protecting yourself through the LLC. In this case, you can have the best of both worlds.
Like an LLC, S-Corporations are a pass-through entity. This means that any income or loss from the company passes through the incorporation to the owners’ personal tax return. Every year, a S-Corporation files Form 1120S where income, gains, losses, deductions, credits, etc. of a domestic corporation or other entity for that tax year are reported. Just like an LLC, the pass-through designation allows S-Corporations to avoid double taxation on corporate income.
The place where an S-Corporation really differs from an LLC or any other partnership is how owners are viewed for tax purposes. In the case of S-Corporations, owners are viewed as employees who work for the business and will be taxed not as an owner, but an employee. This is a key difference that makes S-Corp designations for LLCs a very popular choice.
Breaking it Down
Let’s say that you formed your own LLC and your company is making a profit of $200,000 a year. As the sole owner, all of that “passes through” to you and is included in your income tax filing at the end of the year. Using the IRS’s current rate of 15.3% for self employment tax and Quickbooks’ free self-employed tax calculator, we can see that the total tax owed would be $30,600 with $24,800 going to Social Security and $5,800 going to Medicare. As you can see, Medicare and Social Security tax can add up pretty quickly and make up a substantial amount of your end of the year taxes.
However, if you elected to have your LLC taxed as an S-Corporation, you could save some money when it comes to Social Security and Medicare. Imagine that your company that has elected to be taxed an S-Corp made a profit of $200,000 last year. Because you are now an employee of your company and have to receive a “reasonable salary” according to the IRS, you receive a salary of $100,000 a year. Your salary would be taxed at the same self-employment tax rate as above but you would be paying only $12,400 in Social Security tax and $2,900 in Medicare Tax. The remaining $100,000 is reported as an S-Corporation distribution on your tax return, not employee salary. You will still have to pay State and Federal income tax on that amount, but you will not have to pay Social Security and Medicare tax. The S-Corporation tax designation is the only business entity form that allows owners to save on Social Security and Medicare taxes.
And if you’re asking, no, you can’t give yourself no salary and completely save on Social Security and taxes. The salary you receive must be similar to other positions in the same field.
Electing S Corporation Status
You have now seen the benefit of pursuing an S-Corp tax designation for your LLC but how do you do it? No LLC automatically starts out with the S-Corp designation but it is a relatively easy process. All that is needed is for you to file Form 2553 with the IRS and meeting the basic requirements of an S-Corp:
- There is only one class of stock – i.e. no special rights certain owners or employees
- There are no more than 100 shareholders
- The shareholders are not other business entities
You have 75 days from the formation of your LLC to file for an S-Corporation designation and the IRS recommends that you take your time to file for designation as it would like you to begin conducting business before filing. Additionally, if you missed the filing date, there are a multitude of exceptions that would allow you to file after the date. Rev. Proc. 2013-30 provides specific guidance for late action relief. If you find that your LLC wouldn’t qualify under any of those exceptions, you can also request a letter ruling for a fee here.
It’s also important to remember that once you select this designation, you can’t submit to change your designation for another 60 months unless with special permission from the IRS.
Keep in Mind
There are a couple of things you should keep in mind before electing S-Corp status for your LLC.
- Most LLC entities begin with an operating agreement that is either prepared by a business attorney specifically for an LLC or use an operating agreement template from an online website. It’s important to review your agreement so that it meets the requirements of an S-Corp in regards to tax issues and ensuring that there is only a single class of stock. Your LLC should meet the requirements of an S-Corporation at the time of filing.
- S-Corporations allow you to save money on Social Security tax and Medicare tax by treating you as an employee. Your salary will be taxed but additional distributions will only be subject to state and federal income taxes, not Social Security and Medicare.
- File for an S-Corporation designation within 75 days of forming your LLC using Form 2553.
- With an S-Corporation, your shareholders need to be either U.S. Citizens or U.S. residents. With an LLC or C-Corporation, they do not.